Editor’s note: This article, by Professor Philip Booth, editorial and program director at the Institute of Economic Affairs, the UK free-market think tank, examines some of the underlying issues that arise following the recent scandals concerning the LIBOR interbank interest rate system. While we understand that investigations are ongoing and more banks may be punished following the fines on Barclays, it is important at this stage to explore some of the issues beneath the headlines. The financial products sold to wealth management clients are, in part, linked to the LIBOR system. This publication should stress that while it does not necessarily endorse all the opinions expressed here, it is delighted to share these insights. Please do respond with your views.
Last week a major scandal came to light in the UK with regard to the setting of LIBOR, which is the interest rate at which banks lend to each other. It would appear that this rate, which is a useful index of short-term interest rates by which interest rates on other contracts (including mortgages) are set, was manipulated by traders in a particular financial institution. Presumably this was done for their own gain – at the expense of others who were counterparties to the contracts.
There have been the predictable calls for regulation. The French have said that this is a problem of rampant Anglo-Saxon capitalism which needs regulating – ignoring the fact that EURIBOR uses a more or less identical system. Mark Hoban – the relevant government minister – has said both that this is a moral problem and that LIBOR should be regulated. Others have said that the problem is that we have nationalized central banks setting interest rates. Still elsewhere, it has been suggested that the problem is that we have a banking cartel and we need more competition.
The latter two positions have been taken by respected free-market commentators, but I don’t think they are correct. Certainly, central banks distort LIBOR. They do this both because they determine very-short-term interest rates which feed into LIBOR indirectly and also because they try to smooth liquidity in the market. However, even if central banks did not do this, there would probably be a need for something like LIBOR as a base interest rate that is used to set interest rates on other financial transactions. In fact, LIBOR is a very useful market instrument because it means that banks can lend to and take deposits from customers at a rate which is always related to an objective and transparent market interest rate. Customers can be sure that they will not get taken for a ride. At the same time, the bank will know that it can always get funding for or make deposits at roughly that rate. Without LIBOR long-term, floating-rate mortgages would be that much more risky.
The bank cartel argument is also something of a red herring. Yes, it is true that the smaller the number of banks, the easier it is to manipulate the rate, but there are 16 banks on the sterling LIBOR panel, so the cartel argument is stretching things somewhat.
However, the main threat comes from those who only have the regulatory hammer and think that regulation is the only solution to any problem.